Valuation Insights From Warne v. Commissioner

Re: Estate of Miriam M. Warne et al. v. Commissioner; No. 7019-18; No. 7020-18; T.C. Memo. 2021-17

In the Estate of Miriam Warne (“Estate”), T.C. Memo 2021-17 Tax Court Judge Buch was asked to determine the estate and gift tax values of certain real estate holding limited liability companies (“LLCs”) that held income-producing ground leases in several properties located in California.

History & Background

During the final years of her life, Ms. Warne gifted fractional interests in LLCs to her family members. The LLCs were owned by a family trust and when Ms. Warne passed away in 2014, the Warne Family Trust (“Family Trust”) held majority interests in the five LLCs[1]. The underlying operating agreements of the LLCs granted the majority interest holder considerable power, including the ability to appoint and remove the manager and, together with the manager elect to dissolve the LLC. The remaining minority interests were owned in various amounts by family members and a sub-trust of the Family Trust. The Estate also donated its 100% member interest in Royal Gardens, LLC (“RG”) by splitting that donation between two charitable organizations, with 25% going to a church and 75% to a family foundation.

Expert appraisers were hired by the estate and the IRS to determine the fair market value of the three leased fee interests. Each appraiser calculated the present value of each property by determining the market value of the land and then selected appropriate discount rates for lack of control and marketability to compute the fair market value of the subject interests. Based thereon the Commissioner issued notices of deficiency determining a gift tax deficiency for 2012 and an estate tax deficiency. In calculating the gift and estate tax deficiencies, the expert for the IRS determined an increased fair market value of the LLCs on the basis of his valuations of the ground leases. In calculating the estate tax deficiency, the expert for the IRS also determined more modest discounts for lack of control and marketability than the Estate had used for the remaining LLC interests held by the Estate, and determined that a discount should be applied when calculating the value of the split donation.

Given the diverging valuations and “shortcomings in their analyses”, the Tax Court was forced to make its own valuations relying on the experts’ testimony and underlying data. The primary issues taken up at trial were: (i) determining the fair market values for three properties held by the LLCs[2]; (ii) selecting the appropriate discounts for lack of control and marketability; and (iii) whether minority interest discounts should be applied to the charitable contribution deductions. We briefly summarize these issues and provide key takeaways for both attorneys and appraisers in the sections that follow.

Selecting Discounts for Lack of Control and Marketability

Discount for Lack of Control

Both experts applied their respective discounts for lack of control and marketability consistently to each majority interest in the LLCs held by the Family Trust. To determine the appropriate discount for lack of control, the Estate’s expert examined data published from the Mergerstat Control Premium Study (“MCP”), an empirical study that measures control premiums on transactions of publicly traded companies. More specifically, the expert used the MCP data to compare premiums paid to acquire 50.1% to 89.9% controlling interests with those paid to acquire 90% to 100% interests. The expert further explained to the Tax Court that the difference in premiums between the two blocks suggested a discount for controlling interests that lacked total control. Next, the expert considered factors specific to the LLCs, including the hypothetical possibility of expensive litigation that might be incurred if the majority interest holder were to attempt to liquidate/dissolve the entities. Overall, the expert selected a 5% discount for lack of full control.

Conversely, the expert for the IRS utilized nine closed-end real estate funds to calculate the discount for lack of control (“CE Study”). The data from the CE Study indicated discounts for lack of control ranging from 3.5% to 15.7%, with a median discount of 11.9%. Interestingly, when the expert for the IRS compared the marketable guideline closed-end funds to the subject interests of the underlying LLC, he indicated that that closed-end funds were “minority interests and completely devoid of any control.” As a result, the expert for the IRS believed that a discount for lack of control at the “bottom of the range” of the observed closed-end discount rates was appropriate, or 2%.

Upon consideration of the expert’s findings, the Tax Court, determined it would accept a slight discount given both experts had presented such discounts (while noting that it had previously ruled no discounts for lack of control should be applied for similar majority controlling interests). This is significant given that the Tax Court highlighted that that majority interests being valued had significant power, including the power to dissolve and to remove and/or appoint managers. As a result, the question then became: what was the magnitude of the discount for lack of full control that should be applied in this particular case?

Ultimately, the Tax Court found that the CE Study used by the expert for the IRS were not sufficiently comparable and that a larger sample size would have been more appropriate given such dissimilarities between the dataset and the LLCs. Given the shortcomings in the analysis, the Tax Court believed that the CE Study was inappropriate for the LLCs and declined to adopt IRS expert’s analysis. In addition and of importance to note, the Tax Court also “hesitate[d] to adopt” the Estate’s expert indicated range for the discount of lack of control of 5% to 8%, finding that the Estate’s expert believed a higher rate was warranted to due to the potential risk for future litigation. Given that no evidence of current or future possible litigation was presented, the Tax Court determined a 4% discount for lack of control, which fell within the range of the discounts selected by the experts, was appropriate in this context.

Discount for Lack of Marketability

For the discount for lack of marketability, the experts relied upon similar restricted stock data albeit utilizing different approaches. The expert for the Estate used the Stout Restricted Stock study (“SRS”) and compared each of the LLCs to the SRS dataset based on unique financial characteristics attributable to each LLC. Given that the hypothetical holder of the majority interests had the ability to dissolve the LLCs, the Estate’s expert felt it most appropriate to look at the restricted stock data with the most liquid interests (e.g., with holding periods of six months or less) and determined that a discount of 5% for lack of marketability was appropriate.

In contrast, the expert for the IRS used the Pluris DLOM database, which included 2,398 private placement transactions with an average and median discount for lack of marketability of 21.4% and 18.6%, respectively. The expert then divided the dataset into quintiles according to discount rate, with quintile one reflecting the lowest discounts. Next, the IRS expert calculated median values of stock price per share, market value, book value, market-to-book ratio, trading volume, and block size of the companies within each quintile and calculated a 14.5% average discount for lack of marketability by weighting every factor equally. The expert for the IRS then considered LLC’s strongest and weakest qualities and concluded that a discount for lack of marketability of 2% was appropriate.

After consideration of the expert’s testimony and report findings, the Tax Court selected a discount for lack of marketability of 5% (which was at the lower end of the tax payer’s expert’s range) as the Tax Court found the Estate’s expert more creditable and appreciated the thoroughness of the analysis performed. In an interesting rebuke of the expert for the IRS, the Tax Court communicated that the IRS expert appeared to make a visceral reduction of the discount for lack of marketability rate data instead of a statistical one and that such conclusion was reached without justification.

Should Minority Interest Discounts Be Applied to the Charitable Contribution Deductions?

The Tax Court stated that the proper valuation of charitable bequests of an entire LLC to two different charitable organizations is computed based on the value of what the organizations received, thus the Estate must include 100 percent of the value of the LLC but it may deduct only the sum of the discounted values received by the charities.

The key for this particular issue was not what was given but rather what was received. The Tax Court agreed and quoted Ahmanson Foundation v. United States (“Ahmanson”): “In short, when valuing charitable contributions, we do not value what an estate contributed; we value what the charitable organizations received.”[3] The Tax Court also quoted Ahmanson in regard to the inclusion in the estate, “when valuing an asset as part of an estate, we value the entire interest held by the estate, without regard to the later disposition of that asset.”[4]

The parties involved previously had reached an agreement regarding the amounts of the discounts if the Tax Court determined that discounts were appropriate in determining the charitable deduction for the charitable transfers to the church and to the foundation. More precisely, the parties stipulated that in the event the Tax Court found a discount applied, a 27.385% discount was appropriate for the 25% interest donated to the Church, and that a 4% discount applied to the Estate’s 75% donation to the foundation. This resulted in a significant reduction in the value of charitable contribution for the tax payer of over $2.5 million.

Attorney Takeaways

• This article illustrates that even when 100% of a decedent’s interest in a property is donated to charitable beneficiaries, valuation discounts may still apply resulting in the =Estate paying additional/unforeseen estate tax. If the Estate in this case had left the interest in the LLC to only one of the charities (instead of two), it would have received a full charitable deduction, resulting in no estate tax payable with respect to such property.
• Charitable planning for noncash assets is one of the most complex areas of the tax code. Plan ahead and reach out to qualified appraisers that have the experience and have relationships with other experts and intermediaries so that proper planning and execution is ensured.
• Have a working knowledge of basic valuation concepts so that you can effectively communicate with and understand your hired expert’s opinions and rationale as well as efficiently cross examine the opposing party’s hired expert.
• If you have questions or do not understand the analysis included in an expert’s report, have them earn your understanding. Not only will this enhance pre-existing valuation knowledge, it also allows one to see how effective the hired expert is at explaining their valuation methodologies and defending their analyses.

Appraiser Takeaways

• Applying a discount for lack of control (or impairment of control) to a majority interest holder whose operating agreement provides them with the ability dissolve/liquidate the business and remove or replace existing management has now been established. Of course the ability to do so going forward remains fact specific and highly dependent on the persuasiveness/credibility of the hired qualified appraiser’s valuation report and testimony. While the Tax Court may use expert analysis and findings to guide its conclusions, they are not bound by their approaches, methods, or opinions. Indeed, one expert may be credible/persuasive on one issue while the other party’s expert is more so on another matter.
• Avoid using hypothetical scenarios to justify selecting a higher discount for lack of control. In this case, the Estate’s expert appears to have stepped outside the bounds of fair market value by speculating that any attempt by the majority interest holder to dissolve the LLCs would be met with “strong opposition and potential litigation” from other Warne family members. The Tax Court did not believe it could give any meaningful weight to his speculation and ultimately selected an independently determined discount for lack of full control.
• Opinions formed based on thoughtful, thorough, and robust analysis can effectively sway a judge in the end, even when the judge finds “shortcomings” in your analysis.

Matthew Springer, MBA, ASA, ABV is a Director of Convergent Capital Appraisers, a business valuation firm headquartered in Houston, Texas.

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This article is an abbreviated discussion of complex topics and does not constitute advice to be applied to any specific situation. No valuation, tax or legal advice is provided herein. Readers should seek the services of a skilled and trained professional.